Overview Of Financial Systems PDF

OVERVIEW OF FINANCIAL SYSTEMS Organization of the Chapter Why Study Financial Systems Functions of Financial System Components of A Financial System Financial Markets Financial Institutions Financial Instruments  OVERVIEW OF FINANCIAL SYSTEMS I...

OVERVIEW OF FINANCIAL SYSTEMS Organization of the Chapter Why Study Financial Systems Functions of Financial System Components of A Financial System Financial Markets Financial Institutions Financial Instruments  OVERVIEW OF FINANCIAL SYSTEMS I. WHY STUDY FINANCIAL SYSTEMS You may at times come across news on RBI’s decision to go for a rate cut or not to go for a rate cut. Why RBI considers a rate cut and what effect might this have on the interest rate of an automobile loan when you finance your purchase a new car? Does it mean that a house will be more or less affordable in the future? Will it make it easier or harder for you to get a job next year? In this course we will examine how financial markets (such as those for bonds, stocks, and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other institutions) work and also explore the role of money in the economy. Financial markets and institutions affect not only your everyday life but also the flow of trillions of Rupees of funds throughout our economy, which in turn affects business profits, the production of goods and services, and even the economic well-being of countries other than the United States. What happens to financial markets, financial institutions, and money is of great concern to politicians and can have a major impact on elections. The study of money, banking, and financial markets will reward you with an understanding of many exciting issues. Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage are called financial markets. Financial markets, such as bond and stock markets, are crucial to promoting greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. Indeed, well-functioning financial markets are a key factor in producing high economic growth, and poorly performing financial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have a direct effect on personal wealth, the behavior of businesses and consumers, and the cyclical performance of the economy. Today we use a lot of electronic and electrical equipment starting from fan light, TVs, refrigerators, ACs, mobile phones and so on. Most of these products were not invented by industrialists. When an individual or a group of individuals come up with a new idea, commercialization of the idea requires funds. Financial markets (bond and stock markets) and financial intermediaries (such as banks, insurance companies, and pension funds) serve the basic function of bridging the gap between the inventor and the people with extra funds so that funds can move from those who have a surplus of funds to those who have a shortage of funds. Similarly, when a local government needs to build a road or a school, it may require more funds than local property taxes provide. Well-functioning financial markets and financial intermediaries are crucial to economic health. II. FUNCTIONS OF FINANCIAL SYSTEMS A developed and efficient financial system is highly beneficial for economic growth and development as it performs certain very important functions. First of all, it acts as a link between the savers and the investors by mobilizing and allocating resources from the savers to the investors. This in turn reduces transaction costs. Second, it not only allocates funds to projects for investments, but also entails monitoring of the project performance. Since poor corporate performance results in bankruptcies and takeovers, project monitoring is an important task of the financial system. Third, efficiency of a financial system makes payment and settlement mechanism also highly efficient which are backbone of a modern economic system. Fourth, it facilitates the process of optimum risk allocation. It limits, pools and trades in risks involved in mobilizing savings and allocating credits. Risks are reduced by laying rules governing the operations, holding diversified portfolios and screening of borrowers. Fifth, it performs a very important task of disseminating price related information which assists the investors in decision making and the managements of corporations to evaluate and revise their strategies. Overall it reduces information asymmetry. Sixth, it also offers portfolio adjustment facility which includes services of providing a quick, cheap and reliable way of buying and selling a wide variety of financial assets. And, seventh, a well developed financial system helps in financial deepening and broadening. Financial deepening refers to the increase in liquid financial assets as a percentage of GDP. Financial broadening is measured in terms increase in the number and variety of participants and instruments. III. COMPONENTS OF A FINANCIAL SYSTEM The financial system has six parts, each of which plays a fundamental role in our economy. Those parts are money, financial instruments, financial institutions, financial markets, government regulatory agencies, and central banks. We use the first part of the system, money, to pay for our purchases and to store our wealth. We use the second part, financial instruments, to transfer resources from savers to investors and to transfer risk to those who are best equipped to bear it. Stocks, mortgages, and insurance policies are examples of financial instruments. Financial institutions, the fourth part of the financial system, provide a myriad of services, including access to the financial markets and collection of information about prospective borrowers to ensure they are creditworthy. Banks, securities firms, and insurance companies are examples of financial institutions. The fourth part of our financial system, financial markets, allows us to buy and sell financial instruments quickly and cheaply. BSE (previously The Bombay Stock Exchange) is an example of a financial market. Government regulatory agencies form the fifth part of the financial system. They are responsible for making sure that the elements of the financial system—including its instruments, markets, and institutions—operate in a safe and reliable manner. Finally, central banks, the sixth part of the system, monitor and stabilize the economy. The Reserve Bank of India (RBI) is the central bank of India. While the essential functions that define these six categories endure, their forms are constantly evolving. Money once consisted of gold and silver coins. These were eventually replaced by paper currency, which today is being eclipsed by electronic funds transfers. Methods of accessing means of payment have changed dramatically as well. Even in the beginning of 21 st century, people customarily obtained currency from bank tellers when they cashed their paychecks or withdrew their savings from the local bank. Today, they can get cash from practically any ATM anywhere in the world. To pay their bills, people once wrote checks and put them in the mail, and then waited for their monthly bank statements to make sure the transactions had been processed correctly. Today, payments can be made automatically, and account holders can check the transactions at any time on their bank’s website or on their smartphone. Financial instruments (or securities, as they are often called) have evolved just as much as currency. In the last few centuries, investors could buy individual stocks through stockbrokers, but the transactions were costly. Furthermore, putting together a portfolio of even a small number of stocks and bonds was extremely time consuming; just collecting the information necessary to evaluate a potential investment was a daunting task. As a result, investing was an activity reserved for the wealthy. Today, financial institutions offer people with as little as a few hundred rupees to invest in mutual funds, which pool the savings of a large number of investors. Because of their size, mutual funds can construct portfolios of hundreds or even thousands of different stocks and/or bonds. The markets where stocks and bonds are sold have undergone a similar transformation. Originally, financial markets were located in coffeehouses and taverns where individuals met to exchange financial instruments. The next step was to create organized markets, like the NSE in India—trading places specifically dedicated to the buying and selling of stocks and bonds. Today, most of the activity that once occurred at these big-city financial exchanges is handled by electronic networks. Buyers and sellers obtain price information and initiate transactions from their desktop computers or from handheld devices. Because electronic networks have reduced the cost of processing financial transactions, even small investors can afford to participate in them. Just as important, today’s financial markets offer a much broader array of financial instruments than those available even 50 years ago. Financial institutions have changed, as well. Banks began as vaults where people could store their valuables. Gradually, they developed into institutions that accepted deposits and made loans. For hundreds of years, in fact, that was what bankers did. Today, a bank is more like a financial supermarket. Walk in and you will discover a huge assortment of financial products and services for sale, from access to the financial markets to insurance policies, mortgages, consumer credit, and even investment advice. The activities of government regulatory agencies and the design of regulation have been evolving and have entered a period of more rapid change, too. In the aftermath of the financial crisis of 1929–1933, when the failure of thousands of banks led to the Great Depression, the U.S. government introduced regulatory agencies to provide wide-ranging financial regulation—rules for the operation of financial institutions and markets—and supervision—oversight through examination and enforcement. The U.S. agencies established in the 1930s to issue and enforce these financial rules still operate. Finally, central banks also have changed a great deal. They began as large private banks founded by monarchs to finance wars. Eventually, these government treasuries grew into the modern central banks we know today. While only a few central banks existed in 1900, now nearly every country in the world has one, and they have become one of the most important institutions in government. Central banks control the availability of money and credit to promote low inflation, high growth, and the stability of the financial system. Next, we discuss three of these components to give a brief overview of the same, namely financial markets, financial institutions and financial instruments. Money and central banks will be dealt with at length in separate modules. IV. FINANCIAL MARKETS Financial markets are the centres or arrangements that provide facilities for buying and selling of financial products, like stocks and bonds. Financial markets perform the essential economic function of channelling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they wish to spend more than their income. The flow of funds is shown below in the schematic representation. In direct finance borrowers borrow funds directly from the lenders in the financial markets by selling them securities. In indirect finance the financial intermediaries intervene. Financial markets are critical for producing an efficient allocation of capital (wealth, either financial or physical that is employed to produce more wealth) which contributes to higher production and efficiency for the overall economy. Next the structure or classification of financial markets is discussed. Money and Capital Markets–these markets are defined in terms of the maturity of the securities trades. Only short-term instruments having a maturity period of one year or less are traded in money market whereas in the capital market long term debt and equity instruments having maturity of more than one year are traded. Since, money market instruments are short- term, they are more liquid. Consequently, corporations and banks actively use the money market to earn interest on temporarily available surpluses. Capital market instruments are primarily held by insurance companies or pension funds which are more certain about availability of funds in future. The functions performed by money market are broadly, i) To provide a balancing mechanism to even out the demand for and supply of short- term funds. ii) To provide a focal point for central bank intervention for influencing liquidity and general level of interest rates. iii) To facilitate the development of a market for long term securities. The short-term interest rates serve as a benchmark for longer term financial instruments. Capital market facilitates economic growth through i) Issue of primary securities in the primary market, i.e. directing cash flow from the surplus to the deficit sectors, both government and corporates ii) Issue of secondary securities in the primary market, i.e. directing cash flow from the surplus sector to financial intermediaries such as banks and NBFCs iii) Transaction in outstanding securities which facilitates liquidity. Thus, capital market can be divided into primary and secondary capital market. Primary and Secondary Market - A primary market is a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by corporates or government. This enables the companies to invest the proceeds from a primary issue in creating productive capacities, increasing efficiency, and creating jobs. The primary markets for securities are not well known to the public because the selling of securities to initial buyers often takes place behind closed doors. An important financial institution that assists in the initial sale of securities in the primary market is the investment bank. It does this by underwriting securities: it guarantees a price for a corporation's securities and then sells them to the public. A secondary market is a financial market in which securities that have been previously issued can be resold, e.g. BSE, NSE in India and New York Stock Exchange and NASDAQ in the US. In India the Securities Contract (Regulation) Act, 1956 [SCRA] defines ‘Stock Exchange’ as a body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. Stock exchange could be a regional stock exchange whose area of operation/jurisdiction is specified at the time of its recognition or national exchanges, which are permitted to have nationwide trading since inception. Other examples of secondary markets are foreign exchange markets, futures markets, and options markets. When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve three important functions. i) First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. ii) Second, they determine the price of the security that the issuing firm sells in the primary market. The investors who buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security’s price in the secondary market, the higher the price that the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Conditions in the secondary market are therefore the most relevant to corporations issuing securities. iii) It creates a wealth effect. The Bull Run in the stock market adds to the market capitalization which accrues to all investors, and it makes them feel wealthier. Also, frequent dividend distribution creates wealth for the investors. After the initiation of reforms in 1991, the Indian secondary market went through several changes. Currently there are seven SEBI recognized stock exchanges in India. They are,  BSE Ltd.  Calcutta Stock Exchange Ltd.  Metropolitan Stock Exchange of India Ltd.  Multi Commodity Exchange of India Ltd.  National Commodity and Derivatives Exchange Ltd.  Indian Commodity Exchange Ltd.  National Stock Exchange of India Ltd. Debt and Equity versus Derivative Markets – A useful way to think of the structure of financial markets is to distinguish between markets where debt and equity are traded and those where derivative instruments are traded. Debt markets are the markets for loans, mortgages, and bonds—the instruments that allow for the transfer of resources from lenders to borrowers and at the same time give investors a store of value for their wealth. Equity markets are the markets for stocks. For the most part, stocks are traded in the countries where the companies are based. U.S. companies’ stocks are traded in the United States, Japanese stocks in Japan, Chinese stocks in China, and so on. Derivative markets are the markets where investors trade instruments like futures, options, and swaps, which are designed primarily to transfer risk. To put it another way, in debt and equity markets, actual claims are bought and sold for immediate cash payment; in derivative markets, investors make agreements that are settled later. The main difference between these two markets are,  Trading instruments are different, as mentioned above  Settlement pattern varies - In debt and equity markets actual claims are bought and sold for immediate cash payments, while in derivative markets investors make agreements that are settled later.  Derivative instruments are primarily traded to transfer risks In India, three markets that trade financial derivative instruments are BSE, NSE and Metropolitan Stock Exchange of India Ltd. The exchanges that are permitted to operate in the commodity derivatives segment are BSE Ltd., Multi Commodity Exchange of India Ltd., National Commodity and Derivatives Exchange Ltd., National Stock Exchange of India Ltd. and Indian Commodity Exchange Ltd. Centralised Exchanges, Over-the-Counter Markets, and Electronic Communication Networks (ECNs) – The organization of secondary markets for stocks and other securities is changing rapidly. Historically, there have been two types of financial market: centralized exchanges and over-the-counter (OTC) markets. In an over the counter (OTC) market, dealers at different locations who have an inventory of securities stand ready to buy and sell securities "over the counter" to anyone who comes to them and is willing to accept their prices. Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive. Many common stocks are traded over-the-counter, although a majority of the largest corporations have their shares traded at organized stock exchanges. Some organizations, like the New York Stock Exchange (NYSE) and the large exchanges in London and Tokyo, originated as centralized exchanges, where dealers gathered in person to trade stocks, usually through a system of “open outcry”—shouting bids and offers or using hand signals to make agreements. Others, like the Nasdaq, developed as OTC markets, which are collections of dealers who trade with one another via computer (or, formerly, via phone) from wherever they sit. More recently, electronic communication networks (ECNs) have enabled traders (or their brokers) to find counterparties who wish to trade in specific stocks, including those listed on an exchange. The organization of secondary financial markets is changing rapidly. Today we have electronic communication networks like Instinet and Archipelago. ECNs are part of a class of exchange called alternative trading systems (ATS). They connect buyers and sellers directly and thus because of a reduced transaction cost, they pose a competitive threat to the traditional exchanges. Also, ECNs allow trading activities to continue beyond the usual schedule of centralised exchanges. ECNs trade stocks that are listed with the centralised exchanges. However, they primarily serve institutional investors. The pace of structural change has accelerated dramatically in the past few years, driven by (1) ongoing technological advances in computing and communications and (2) increasing globalization. The former dramatically lowered the importance of a physical location of an exchange—as new technology allowed the rapid low-cost transmission of orders across long distances—while the latter encouraged unprecedented cross-border mergers of exchanges, integrating larger pools of providers and users of funds. As part of this process, electronic OTC markets like the Nasdaq and some ECNs have gained the official status of regulated exchanges without establishing a central place of operation. Shifting in the opposite direction, the NYSE has been acquired by Intercontinental Exchange (ICE). And, today a large share of equity trading takes place away from the NYSE floor. Even there, the old system of open outcry has been replaced (as on most exchanges) by computers that record orders, execute transactions, and report trades. Trading on decentralized electronic exchanges—rather than a physically central one—has advantages and disadvantages. On the plus side, customers can see the orders, the orders are executed quickly, trading occurs 24 hours a day, and costs are low. In addition, decentralization reduces a menacing operational risk that became evident on September 11, 2001, a time before computers dominated the floor of the NYSE and people still depended on gathering there to trade. The NYSE building stood only a few blocks from the World Trade Center. Although the NYSE building was not damaged when the Twin Towers fell, the floor of the exchange became inaccessible. Because trading on the NYSE depended on people meeting there, trading stopped; it did not resume until Monday, September 17. Yet, while New York dealers were shut down, dealers elsewhere in the country could trade via the Nasdaq. But no system of trading is free of problems. On the minus side, electronic operations have proven prone to errors that threaten the existence of brokers. In addition, amid the complex system of multiple, imperfectly linked exchanges, new trading patterns have arisen that render the entire system fragile, raising serious worries among investors about the liquidity and value of their stocks. For example, consider the following events. On December 8, 2005, a “fat-finger incident” cost a Japanese broker more than $300 million when an employee mistyped a sell order. The Regional Stock Exchanges started clustering from the year 1894, when the first RSE, the Ahmedabad Stock Exchange (ASE) was established. In the year 1908, the second in the series, Calcutta Stock Exchange (CSE) came into existence. 1980s was the turning point when many RSEs were incorporated. Till 2014 there were 20 odd RSEs though most of them were dormant and their activities were mainly routed through subsidiaries which had taken up trading membership of BSE and NSE. However, in 2014 SEBI’s new norms for stock exchanges mandated a minimum net worth of Rs.100 crore and an annual trading of Rs.1,000 crore. The stock market regulator gave the recognized stock exchanges two years to comply or exit the business. Consequently, as on May 08, 2019, 20 RSEs had been granted exit by the SEBI. OTCEI in India was set up in 1990 as a stock exchange providing small and medium-sized companies a means to generate capital and it commenced its operation in 1992. However, the OTCEI was de-recognised by SEBI vide its order dated 31 Mar 2015. In the US, though NASDAQ is a dealer based exchange it is not classified as an OTC market. Rather, OTC markets generally list small companies and often these small companies have ‘fallen off’ from more organized exchanges; they are unlisted companies. In India NSE provides a nationwide, on-line fully automated screen-based trading system (SBTS) or platform like NASDAQ. It is the first exchange in the world to use satellite communication technology for trading. NSE, set up in 1994, is the first modern stock exchange to bring in new technology, new trading practices, new institutions, and new products in India. In India in the face of severe competition, the RSEs formed Federation of Indian Stock Exchanges (FISE) in 1996 which proposed an Inter-Connected market system (ICSM) with technical assistance from US Agency for International Development – Financial Institution Reforms and Expansion (USAID – FIRE). Thus, Inter-Connected Stock Exchange (ISE) was formed which got recognition from SEBI in 1998 and started its operations in Feb 1999. It opened a new national segment of trade to all registered members of the participating exchanges with direct access to its national level trading platform on an equal footing regardless of the location and the financial strength of the participating exchange. It provided a highly automated trading system. ISE was a stock exchange of stock exchanges since members of the participating exchanges are the only traders on the ISE. However, ISE was also granted exit by SEBI in December 08, 2014. V. FINANCIAL INSTITUTIONS Financial institutions are business organizations that mobilise and act as depositories of savings and as purveyors of credit or finance. They also provide various financial services like providing loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities, leasing, hire-purchase, and insurance business. First we need to talk about the roles and importance of financial institutions. Financial institutions reduce transactions costs by specializing in the issuance of standardized securities. They reduce the information costs of screening and monitoring borrowers to make sure they are creditworthy and they use the proceeds of a loan or security issue properly. In other words, financial institutions curb information asymmetries and the problems that go along with them, helping resources flow to their most productive uses. Further, even though financial institutions make long-term loans, they also give savers ready access to their funds. That is, they issue short-term liabilities to lenders while making long- term loans to borrowers. By making loans to many different borrowers at once, financial institutions can provide savers with financial instruments that are both more liquid and less risky than the individual stocks and bonds they would purchase directly in financial markets. The following figure is a schematic overview of the financial system. It shows that there are two types of financial institutions: those that provide brokerage services (top) and those that transform assets (bottom). Broker institutions give households and corporations access to financial markets and direct finance. Institutions that transform assets, take deposits or investments or issue insurance contracts to households. They use the proceeds to make loans and purchase stocks, bonds, and real estate. That is their transformation function. Financial institutions can be classified as i) banking and non-banking institutions (NBFCs) and ii) intermediaries and non-intermediaries. Though the banking and non-banking financial institutions have a number of things in common, they primarily differ in terms of the latter’s inability to accept demand deposits; e.g. all insurance companies like LIC, GIC, Reliance Capital, Indiabulls, NABARD, SIDBI (Small Industries Development Bank of India) and primary dealers. Two other major differences are i) the NBFCs cannot issue cheques drawn on themselves and ii) they cannot borrow from the RBI. On the other hand, intermediaries intermediate between savers and investors by lending money as well as mobilizing savings. Non-intermediaries also extend loans, but their resources are not directly obtained from the savers. All banking institutions are intermediaries. Many non- banking institutions also act as intermediaries, and they are known as non-bank financial intermediaries (NBFIs). In India, the non-intermediary institutions like IFCI (Industrial Finance Corporation of India) and NABARD (National Bank for Agriculture and Rural Development) have come into existence because of government’s effort to provide assistance for specific purposes, sectors and regions where the credit needs of certain borrower might not be otherwise adequately met by private institutions. A categorization of financial intermediaries is given below. Depository Institutions – these are financial intermediaries that accept deposits from individuals and institutions and make loans. Since deposits are an important component of money supply, these institutions also form a significant part of financial systems. They include commercial banks and thrift institutions like savings and loan associations, mutual savings banks and credit unions. Commercial banks raise funds primarily by issuing chequeable deposits, savings deposits and time deposits. They then use these funds to make commercial, consumer and mortgage loans, and to buy central and state government securities. Thrift institutions primarily are non-profit banks where owners are the customers. So, they get their profits through yearly payback or dividends. For instance, credit unions are typically very small cooperative lending institutions organized around a particular group, like union members, and employees of a particular firm. They acquire funds from deposits called shares and make consumer loans. Contractual Savings Institution- Contractual savings institutions, such as insurance companies and pension funds, are financial intermediaries that acquire funds at periodic intervals on a contractual basis. Because they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years, they do not have to worry as much as depository institutions about losing funds quickly. As a result, the liquidity of assets is not as important a consideration for them as it is for depository institutions, and they tend to invest their funds primarily in long-term securities such as corporate bonds, stocks, and mortgages. Insurance companies – insurance companies can be divided among the following types: i) General Insurance–general insurance covers many insurance services like fire insurance, motor insurance, marine cargo insurance, marine hull insurance, and non-traditional or rural insurance like providing insurance to cattle/hens, crop, water pump and other livestock etc. General insurance has a greater possibility of loss of funds if major disasters occur. For this reason, they use their funds to buy more liquid assets than life insurance companies do. ii) Health insurance – health insurance is defined as effecting of contracts which provide sickness benefits or medical, surgical or hospital expense benefits, whether in-patient or out- patient on an indemnity, reimbursement, service, prepaid hospital, or other plans basis, including assured benefits and long-term care. In India, both life and non-life insurer registered with the IRDA (Insurance Regulatory and Development Authority) can transact health insurance business. iii) Reinsurance – it is insurance of risk assumed by the primary insurer known as the ceding company. The risk is shifted to another insurer known as reinsurer. The amount of insurance retained by the ceding company for its own account is known as retention and the amount ceded to the reinsurer is known as cession. The proportion of retention or cession depends on the ceding company’s assets, investment, income, portfolio of the risk premium levels, inflation, and reinsurance market conditions. This business assumes greater importance in the event of war or natural calamities when the smaller insurance firms find themselves unable to take on the full risk due to their small capital base. The LIC has the financial strength and capacity to absorb the risks fully. Therefore, the sum reinsured is insignificant for life insurance policies. The need for reinsurance is higher for general insurance and till 2000, a huge amount of money was flowing out of the country on account of reinsurance purchased from foreign reinsurers. Since then, IRDA has made GIC as the designated Indian insurer entitled to receive obligatory cession from the private insurance companies. Currently, it is 10 percent of all insurance business by general insurers. iv) Life insurance - Life insurance companies insure people against financial hazards following a death and sell annuities (annual income payments upon retirement). They acquire funds from the premiums that people pay to keep their policies in force and use them mainly to buy corporate bonds and mortgages. They also purchase stocks but are restricted in the amount that they can hold. For instance, in India every life insurer is required to maintain an excess of value of its assets over the amount of liabilities by not less than ₹50 crore. v) Micro insurance–it is provision of insurance to poor. A micro insurance policy has a small sum insured and low premium. It is designed to reduce the fundamental risk of life, living and livelihood. Therefore, it includes term life insurance, accidental death insurance, health insurance, catastrophe insurance, asset insurance and weather insurance. Pension funds and government retirement funds provide retirement income in the form of annuities to employees who are covered by a pension plan. Funds are acquired by contributions from employers and from employees, who either have a contribution automatically deducted from their pay-checks or contribute voluntarily. In India, there are four main categories of pension plans: i) deferred annuity plans, ii) immediate annuity plans, iii) government-backed pension plans and iv) pension plans with life cover. For the first one, the contributors keep paying premiums for certain numbers of years, called accumulation phase. And, after retirement one starts getting pension income, known as the distribution phase. In the second category, annuities are paid immediately after the payment of premium. This is a less popular scheme in India. Government-backed pension plans are pension plans introduced by the government. Examples include National Pension Scheme (NPS), Employee Provident Fund (EPF) and Public Provident Fund (PPF). Finally, under the fourth category, the pension plan not only provide a regular income after retirement, it also offers life coverage. Therefore, in the event of death of the holder of the plan, his/her nominee receives a sum assured. The largest asset holdings of pension funds are corporate bonds and stocks. Investment Intermediaries - This category of financial intermediaries includes finance companies, mutual funds and investment banks. Finance companies raise funds by selling commercial papers (a short-term debt instrument) and by issuing stocks and bonds. They lend these funds to consumers for purchasing items such as furniture, automobiles, and home improvements, and to small businesses. Some finance companies are organized by a parent corporation to help sell its product, e.g. Maruti Finance. Mutual funds acquire funds by selling shares to many individuals and use the proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow shareholders to pool their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks or bonds. In addition, mutual funds allow shareholders to hold more diversified portfolios than they otherwise would. Shareholders can sell (redeem) shares at any time, but the value of these shares will be determined by the value of the mutual fund's holdings of securities. Types of mutual funds: Equity funds/growth funds - Funds that invest in equity shares are called equity funds. They carry the principal objective of capital appreciation of the investment over the medium to long-term. They are best suited for investors who are seeking capital appreciation. They can be further classified as o Diversified funds – these funds invest in companies spread across sectors and ideally meant for risk-averse investors who prefer a diversified portfolio o Sector funds – here the investments are inequity shares of companies in a particular business or sector o Index funds – These funds invest in market indexes like S&P CNX Nifty. The money collected from the investors is invested only in the stocks which represent the index. Tax saving funds – they offer tax benefits to investors in the form of tax rebates Debt/Income funds – these funds invest in high rated fixed income bearing instruments like bonds, govt. securities, commercial papers and other money market instruments. They provide a regular income to the investors and best suited for risk-averse investors looking for capital preservation. Liquid Fund/Money market funds –here the investment is in highly liquid money market instruments. Money market mutual funds have the characteristics of a mutual fund but also function to some extent as a depository institution because they offer deposit-type accounts. Like most mutual funds, they sell shares to acquire funds that are then used to buy money market instruments that are both safe and very liquid. The interest on these assets is paid out to the shareholders. A key feature of these funds is that shareholders can write cheques against the value of their shareholdings. In effect, shares in a money market mutual fund function like checking account deposits that pay interest. Gilt funds – These funds invest in central and state government securities. Balanced funds – this entails investment in both equity shares and fixed-income bearing instruments in some proportion. They have moderate risks, provide a steady return and the volatility of the fund. Investment banks help a corporation issue security. First, it advises the corporation on which type of securities to issue (stocks or bonds); then it helps sell (underwrite) the securities by purchasing them from the corporation at a predetermined price and reselling them in the market. Investment banks also act as deal makers and earn enormous fees by helping corporations acquire other companies through mergers or acquisitions. VI. FINANCIAL INSTRUMENTS Financial (market) instruments are written legal obligations of one party to transfer something of value, usually money, to another party at some future date, under certain conditions. Stocks, loans, insurance all are examples of financial instruments. However, some of the financial instruments are marketable and some are not. The marketable financial instruments are called securities. They perform three functions: i) a means of payment, ii) store of value and iii) transfer of risk. As a means of payments, securities are not yet very commonly accepted. Nevertheless, sometimes companies give their stocks to willing employees as a bonus payment or payment for work. Having a store of value means that your consumption doesn’t need to exactly match your income. For days, months, and years, if necessary, you can spend more than you make, repaying the difference later. Even though most of us are paid weekly or monthly, we eat every day. As stores of value, financial instruments like stocks and bonds are thought to be better than money. Over time, they generate increases in wealth that on average exceed those we can obtain from holding money in most of its forms. These higher payoffs are compensation for higher levels of risk, because the payoffs from holding most financial instruments are generally more uncertain than those that arise from holding money. Nevertheless, many financial instruments can be used to transfer purchasing power into the future. As a store of value, securities perform better than money since they tend to have better yield. And, the third one, i.e. transfer of risk, is a specific task only securities perform and not money. For instance, consider insurance contracts where the risk is transferred from individuals to insurance companies. A house is insured because any damage to the property would imply huge loss. Through insurance the whole or a part of the risk associated with any accidental damage to the property is transferred to the insurance company. Because insurance companies make similar guarantees to a large group of people, they have the capacity to shoulder the risk. Financial instruments differ from each other in terms of their investment characteristics. Some of the important investment characteristics are i) liquidity, which depends on marketability and transferability, ii) transaction costs, iii) risk of default, iv) maturity period, v) tax status vi) volatility of prices and vii) the rate of return. However, the instruments can be categorized in terms of their maturity period and hence the markets they are traded in, i.e. money market instruments and capital market instruments. First, the money market instruments are discussed. Treasury Bills – treasury bills are issued by RBI to finance short term financial requirements of the Government of India (GoI). They are the most important segment of the money market. The advantages with treasury bills are i) highly liquid, ii) negotiable securities, iii) offer risk free investment (almost no possibility of default) iv) provide assure reasonable yield, and v) eligible for inclusion in the securities for SLR. Any banks, other financial institutions, corporate bodies, mutual funds, foreign institutional investors, state governments, provident funds, primary dealers, and foreign banks are eligible to bid and purchase treasury bills. At present, the RBI issues three types of treasury bills through auctions, namely, 91-day, 182-day and 364- day. There are no treasury bills issued by State Governments. Treasury bills are available for a minimum amount of Rs.10,000 and in multiples of Rs. 10,000, for both competitive and non- competitive bidding. Treasury bills are issued at a discount and are redeemed at par. The RBI usually conducts the auctions of T-bills every week on Wednesday. There are two types of auctions. In multiple price-based or French auctions where all bids equal to or above the cut- off price are accepted which exhausts all the issues. However, the bidder must obtain the Treasury bill at the price quoted by him. In uniform price based or Dutch auctions all the bids equal to or above the cut-off price are accepted and the bidders pay a uniform price as decided by the RBI, not the prices quoted by them. Further, the bids submitted can be classified as competitive and non-competitive bids. While competitive bids involve price competition among the participants for T-bills allotment, with a view to encouraging wider participation and retail holding of Government securities, retail investors are allowed participation on “non-competitive” basis in select auctions of dated Government of India (GoI) securities and Treasury Bills under certain T&C. Retail investor, for the purpose of scheme of NCB, is any person, including individuals, firms, companies, corporate bodies, institutions, provident funds, trusts, and any other entity as may be prescribed by RBI. Regional Rural Banks (RRBs) and Cooperative Banks are also covered under this Scheme only in the auctions of dated securities in view of their statutory obligations and shall be eligible to submit their non-competitive bids directly. State Governments, eligible provident funds in India, the Nepal Rashtra Bank, Royal Monetary Authority of Bhutan and any Person or Institution, specified by the RBI, with the approval of Government, shall be covered under this scheme only in the auctions of Treasury Bills without any restriction on the maximum amount of bid for these entities and their bids will be outside the notified amount. Under the Scheme, an investor can make only a single bid in an auction. For retail investors, the allocation will be restricted to a maximum of 5 percent of the aggregate nominal amount of the issue. All the non-competitive bids are accepted at the weighted average price of the competitive bids. Cash management bills – In 2010, Government of India, in consultation with RBI introduced a new short-term instrument, known as CMBs. They have the generic character of T-bills but are issued for maturities less than 91 days. Call or Notice Money Market – it is a key segment of the Indian money market as the day-to- day surplus funds are traded here, mostly by banks. Call money market is a market for uncollateralized lending and borrowing of funds. It is a market for very short-term funds repayable on demand with a maturity period varying between one day to 14 days. When money is lent or borrowed for a day, it is known as call (overnight) money. Intervening holidays or Sundays are not counted. When money is borrowed or lent for more than a day up to 14 days, it is called notice money. These are unsecured, highly risky and volatile transactions. Call money is required primarily for maintaining CRR by the banks. The participants in the call/notice money market are scheduled commercial banks, cooperative banks and primary dealers who are allowed to both lend and borrow. While there are borrowing restrictions on all of them, there is no restriction on the lending limit of cooperative banks. Other non-banking financial institutions are only allowed to lend and are not allowed to borrow from the call/notice money market. Aside: a primary dealer is a firm registered with the RBI and has the license to purchase government securities directly from the RBI for reselling in the securities market. Collateralized borrowing and lending obligations (CBLO) – The Clearing Corporation of India Ltd launched a new product – CBLO on Jan 20, 2003, to provide liquidity to entities hit by restrictions on access to the call money market. CBLO is a discounted instrument available on electronic book entry form for the maturity period between 1 to 19 days. The eligible securities are central government securities including T-bills. The entity type eligible for CBLO Membership are Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions, Insurance Companies, Mutual Funds, Primary Dealers, Bank cum Primary Dealers, NBFC, Corporate, Provident/ Pension Funds etc. Commercial Papers - Commercial papers are unsecured negotiable and transferable promissory notes with a fixed maturity period. They are issued by creditworthy companies and financial institutions to meet their working capital requirement. They are issued at a discounted rate of their face value. Scheduled commercial banks are the major investors in commercial papers. Banks prefer commercial papers over loans since CPs are short term instruments and offer attractive profit conditions. Banks often borrow from call money market to fund investments in CPs. Commercial bills - a commercial bill is a short-term negotiable, and self-liquidating instrument with low risk. Bills of exchange or trade bills are negotiable instruments drawn by the seller on the buyer for the value of the goods delivered. When trade bills are accepted by commercial banks, they are called commercial bills. The maturity period of the bills varies from 30 to 90 days depending on the credit extended by the industry. It is of two types: demand bill and usance bill. A demand bill is payable on demand, i.e. immediately on presentation to the drawee. A usance bill is payable at a future date. Certificates of Deposit – a certificate of deposit is a debt instrument sold by a bank to depositors that pays annual interest and at maturity pays back the original purchase price. They are unsecured short-term instruments issued by commercial banks and developed financial institutions. CDs are time deposits of specific maturity like fixed deposits. The biggest difference between the two is that CDs are negotiable. CDs are issued by banks during periods of tight liquidity at relatively high interest rates. They represent high-cost liability. Banks resort to this source when deposit rate is sluggish, but credit rate is high. Though negotiable, the markets for these deposits have remained dormant since they are high yielding instruments and investors prefer to hold them. Banks can issue CDs for maturities from 7 days to one year whereas eligible FIs can issue for maturities from 1 year to 3 years. Capital market instruments are securities with maturities greater than one year. The principal capital market instruments are discussed below. Stocks - Stocks are equity claims on the net income and assets of a corporation. The total value of stocks traded in India stood at 72.81 percent of its GDP in 2020 (World Bank). However, this percentage seems to have risen to nearly 420 if we consider the total value of stock traded on June 30, 2023 as a percentage of the quarterly GDP during April – June, 2023. Mortgages and Mortgage-backed Securities - Mortgages are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans. Mortgages are provided by savings and loan associations, mutual savings banks, commercial banks and insurance companies. In recent years a growing amount of the funds for mortgages have been provided by mortgage-backed securities, a bond-like instrument backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holder of the security. Corporate Bonds – these are long term bonds issues by corporations with very strong credit ratings. A typical corporate bond sends the holder an interest payment twice a year and pays off the face value when the bond matures. Some corporate bonds called convertible bonds have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date. The principal buyers of corporate bonds are life insurance companies, pension funds, and households. Government Securities -A Government security is a tradable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. Such long-term securities are usually called Government bonds or dated securities with original maturity up to 30 years. In India, the Central Government issues bonds or dated securities and those issued by the State Governments are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free gilt- edged instruments. Government of India also issues savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of India bonds, fertilizer bonds, power bonds, etc.). Consider the nomenclature of a typical fixed coupon Government dated security as 7.49% GS 2017. This implies that the bond makes a coupon payment of 7.49% annually and will expire in 2017. If the date of issues is April 16, 2007, then the bond will expire on April 16, 2017. If two securities have same coupon rates and are due to expire in the same year, then one will have the month also mentioned as a suffix in its nomenclature, e.g. 7.49% GS 2017 FEB. Government dates securities issued in India are of the following types: i) Fixed rate bonds - These are bonds on which the coupon rate is fixed for the entire life of the bond. Most Government bonds are issued as fixed rate bonds. ii) Floating Rate Bonds (FRB) – FRBs are securities which do not have a fixed coupon rate. Instead, it has a variable coupon rate which is re-set at pre-announced intervals (say, every six months or one year). FRBs were first issued in September 1995 in India. For example, an FRB was issued on November 07, 2016 for a tenor of 8 years, thus maturing on November 07, 2024. The variable coupon rate for payment of interest on this FRB 2024 was decided to be the average rate rounded off up to  two decimal places of the implicit yields at the cut-off prices of the last three auctions of 182 day T- Bills, held before the date of notification. The coupon rate for payment of interest on subsequent semi-annual periods was announced to be the average rate (rounded off up to two decimal places) of the implicit yields at the cut- off prices of the last three auctions of 182-day T-Bills held up to the commencement of the respective semi-annual coupon periods. iii) The Floating Rate Bond can also carry the coupon, which will have a base rate plus a fixed spread, to be decided by way of auction mechanism. The spread will be fixed throughout the tenure of the bond. For example, FRB 2031 (auctioned on May 4, 2018) carries the coupon with base rate equivalent to Weighted Average Yield (WAY) of last 3 auctions (from the rate fixing day) of 182 Day T-Bills plus a fixed spread decided by way of auction. iv) Zero Coupon Bonds – Zero coupon bonds are bonds with no coupon payments. However, like T- Bills, they are issued at a discount and redeemed at face value. The Government of India had issued such securities in 1996. It has not issued zero coupon bonds after that. v) Capital Indexed Bonds – These are bonds, the principal of which is linked to an accepted index of inflation with a view to protecting the principal amount of the investors from inflation. A 5-year Capital Indexed Bond was first issued in December 1997 which matured in 2002. vi) Inflation Indexed Bonds (IIBs) - IIBs are bonds wherein both coupon flows, and the principal amounts are protected against inflation. The inflation index used in IIBs may be Wholesale Price Index (WPI) or Consumer Price Index (CPI). Globally, IIBs were first issued in 1981 in UK. In India, Government of India through RBI issued IIBs (linked to WPI) in June 2013. Since then, they were issued on monthly basis till December 2013. Based on the success of these IIBs, Government of India in consultation with RBI issued the IIBs (CPI based) exclusively for the retail customers in December 2013. vii) Bonds with Call/ Put Options – Bonds can also be issued with features of optionality wherein the issuer can have the option to buy-back (call option) or the investor can have the option to sell the bond (put option) to the issuer during the currency of the bond. It may be noted that such bond may have put only or call only or both options. The first G-Sec with both call and put option viz. 6.72% GS 2012 was issued on July 18, 2002 for a maturity of 10 years maturing on July 18, 2012. The optionality  on the bond could be exercised after completion of five years tenure from the date of issuance on any coupon date falling thereafter. The Government has the right to buy-back the bond (call option) at par value (equal to the face value) while the investor had the right to sell the bond (put option) to the Government at par value on any of the half-yearly coupon dates starting from July 18, 2007. viii) Special Securities - Under the market borrowing program, the Government of India also issues, from time to time, special securities to entities like Oil Marketing Companies, Fertilizer Companies, the Food Corporation of India, etc. (popularly called oil bonds, fertiliser bonds and food bonds respectively) as compensation to these companies in lieu of cash subsidies These securities are usually long dated securities and carry a marginally higher coupon over the yield of the dated securities of comparable maturity. The beneficiary entities may divest these securities in the secondary market to banks, insurance companies / Primary Dealers, etc., for raising funds. ix) Government of India has also issued Bank Recapitalisation Bonds to specific Public Sector Banks in 2018. These securities are named as Special GoI security and are non-transferable and are not eligible investment in pursuance of any statutory provisions or directions applicable to investing banks. x) STRIPS – Separate Trading of Registered Interest and Principal of Securities. - STRIPS are the securities created by way of separating the cash flows associated with a regular G-Sec i.e. each semi-annual coupon payment and the final principal payment to be received from the issuer, into separate securities. They are essentially Zero Coupon Bonds (ZCBs). However, they are created out of existing securities only and unlike other securities, are not issued through auctions. Stripped securities represent future cash flows (periodic interest and principal repayment) of an underlying coupon bearing bond. All fixed coupon securities issued by Government of India, irrespective of the year of maturity, are eligible for Stripping/Reconstitution, provided that the securities are reckoned as eligible investment for the purpose of Statutory Liquidity Ratio (SLR) and the securities are transferable. For example, when ₹100 of the 8.60% GS 2028 is stripped, each cash flow of coupon (₹ 4.30 each half year) will become a coupon STRIP and the principal payment (₹100 at maturity) will become a principal STRIP. These cash flows are traded separately as independent securities in the secondary market. xi) Sovereign Gold Bond (SGB): SGBs are unique instruments, prices of which are linked to commodity price viz Gold. SGBs are also budgeted in lieu of market borrowing. The calendar of issuance is published indicating tranche description, date of subscription and date of issuance. The Bonds shall be denominated in units of one gram of gold and multiples thereof. Minimum investment in the Bonds shall be one gram with a maximum limit of subscription per fiscal year of 4 kg for individuals, 4 kg for Hindu Undivided Family (HUF) and 20 kg for trusts and similar entities notified by the Government from time to time, under certain T&C. The Bonds shall be repayable on the expiration of eight years from the date of issue of the Bonds. Pre-mature redemption of the Bond is permitted after fifth year of the date of issue of the Bonds and such repayments shall be made on the next interest payment date. The bonds under SGB Scheme may be held by a person resident in India, or jointly with any other individual or by a Trust, HUFs, Charitable Institution and University. The issue price of the Gold Bonds will be ₹ 50 per gram less than the nominal value to those investors applying online and the payment against the application is made through digital mode. The Bonds shall bear interest at the rate of 2.50 percent (fixed rate) per annum on the nominal value. Interest shall be paid in half-yearly rests and the last interest shall be payable on maturity along with the principal. xii) 7.75% Savings (Taxable) Bonds, 2018: Government of India has decided to issue 7.75% Savings (Taxable) Bonds, 2018 with effect from January 10, 2018. These bonds may be held by (i) an individual, in individual capacity on joint basis, and (ii) a Hindu Undivided Family. There is no maximum limit for investment in these bonds. Interest on these Bonds will be taxable under the Income Tax Act, 1961 as applicable according to the relevant tax status of the Bond holders. These Bonds will be exempt from wealth-tax under the Wealth Tax Act, 1957. These Bonds will be issued at par for a minimum amount of ₹1,000 (face value) and in multiples thereof. Government dated securities are sold through auctions just like Treasury Bills, both multiple price and uniform price type auctions. For newly issued securities, yield-based auctions are conducted while for re-issue of existing securities price-based auctions are conducted. In yield-based auctions, bidders mention yields in their bids; the bids are arranged in ascending order and then starting from the top till the bid against which the  notified amount gets exhausted are considered for allocation. In case of a tie at the last bid considered, the bidders are allocated at a pro-rata basis. On the other hand, for price-based auctions, prices are arranged in descending order and starting from the top, the price at which the notified amount gets exhausted are considered. State and Local Government Bonds – also called municipal bonds are long-term bonds issued by state and local governments to finance expenditure on schools, roads, and other large programmes. In the US interest income from these bonds is exempt from income tax and state taxes in the issuing state. Commercial banks are the biggest buyers of these securities. In India loans raised from the market by State Governments are called State Development loans (SDLs). SDLs are dated securities issued through normal auction similar to the auctions conducted for dated securities issued by the Central Government. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities issued by the Central Government, SDLs issued by the State Governments also qualify for SLR. State Governments have also issued special securities under “Ujjwal Discom Assurance Yojna (UDAY) Scheme for Operational and Financial Turnaround of Power Distribution Companies (DISCOMs)”. In India municipal bond market is still at a very nascent stage. In March 2015, SEBI developed new norms on trading Municipal bonds and as of November 30, 2023, total value of Municipal bonds issued in India stood at Rs 2383.90 crores. References Mishkin, Frederick S. 2019. The Economics of Money, Banking, and Financial Marker, Twelfth Edition. Pearson Education, UK. Cecchetti, Stephen G. & Schoenholtz, Kermit L. Money, Banking, and Financial Market, fifth edition. 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